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The Companion Advisor: Taxes & Estates
Taxes on Mutual Funds

A Companion Advisor Article

"True, you can't take it with you, but then that's not the place where it comes in handy." Brendan Francis

If you are an individual mutual fund investor and a resident of Canada, federal income tax considerations may influence your choice of funds. Although this is a general summary, and is not intended to constitute advice to any particular investor, here are some tax factors to consider.

Unless held within a Registered Retirement Savings Plan, income received from mutual fund distributions, or the selling of fund units, must be declared on your tax return. Each fund you own will send you a tax slip with itemized distributions because each type of income is taxed differently. Capital gains or losses from redemptions of fund units will appear on your annual statement.

Interest income from bond, mortgage, balanced, or money market funds is taxed the most, at the same rate as a salary or pension. Capital gains are taxed on 1/2 of the gain. For example, $500 of a $1000 capital gain is taxable. Canadian Dividends are taxed after being grossed-up by 25% then reduced by an offsetting dividend tax credit.

If you sell fund units and incur a capital loss, this can be used to offset or reduce other capital gains. Capital losses can be carried back to offset gains in any of the previous three years or carried forward indefinitely.

You may receive foreign income if you invest in a fund that owns foreign securities. Foreign interest and dividends are fully taxable in Canada, and are not eligible for dividend tax credits. If foreign tax was withheld before paying income to the fund, however, your tax slip could include an offsetting foreign tax credit.

All these general conditions apply whether your distributions are sent to you by cheque or automatically reinvested in a fund. In either case, the distribution is regarded as income. The amount of the distribution is not pro-rated according to the number of days you actually owned units of the fund. You receive distributions if you own the fund on the distribution date and the entire amount of the distribution is taxable, regardless of the length of time of your ownership.

To avoid double taxation, capital gains or losses are calculated on the Adjusted Cost Base of the investment. This adjusted cost base is increased by the amount of reinvested distributions because they are after-tax amounts.

For example, if you invest $15,000, receive and reinvest a $510 distribution at year end, then purchase an additional $10,000 the next year, your adjusted cost base is as follows:

Unit Adjusted

Transaction	Units	Price	Cost Base
Original Purchase	1,000	$15.00	$15,000
Distribution	30	$17.00	$510
Additional Purchase	550	$18.18	$10,000
Totals	1,580	-	$25,510

If you later sell all your units for $19, your capital gain is as follows:

Proceeds 1580 shares @ $19=$30,020
Less Adjusted Cost Base -$25,510
Capital Gain $4,510

If you purchase mutual funds for a spouse, child, or other family member (nieces, nephews, or grandchildren) you may be subject to tax when distributions are received or fund units sold. This is called attribution.

Also, attribution may apply when gifting or loaning the money to purchase mutual funds. The attribution rules are complicated and depend on your relationship to the recipient and the age of the recipient. Be sure to consult a tax specialist to clarify the exact nature of the attribution, if any.

There are still some tax-reduction strategies available without running afoul of Canada Customs & Revenue Agency:

1) Contribute to a spousal RRSP in the name of a lower-income spouse. You receive the deduction, and your spouse is taxed on any withdrawals made from this spousal RRSP (as long as the withdrawals are made more than three years after your last spousal contribution).

2) The higher-income spouse should pay all household expenses, including the income tax of the lower income spouse. This allows the lower income spouse to make the family investments and be subject to any taxes at a lower rate.

3) Even if attribution applies, gifts and loans may still be a good idea. Once the taxes have been paid on the investment income earned, future earnings on that income are not taxable. Income on income is the tax responsibility of the borrower or receiver of the gift.

4) When buying mutual funds for children, invest in a growth fund that only pays capital gains, which are not subject to attribution, but are instead taxable to the child. It is unlikely that the child will earn enough to be over the taxable threshold, thereby avoiding tax on the capital gains.

Consult both the prospectus of your mutual fund and an independent tax adviser about the tax consequences of investing in mutual funds based on your own particular circumstances.

The reason for reducing taxes is not to take our money with us, but to be able to use it while we're here.

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